The question is – who is going to pay Europe’s debts, not how do we generate enough to pay?

Felix Martin's "Real Money" column.

Both the financial and the political elite of Europe were shocked by the result of the general election in Italy. To the financial markets, the hung parliament that emerged was an unpleasant reminder that the eurozone’s financial crisis remains unresolved. On trading desks in Frankfurt and London, the talk was once again of the euro as a fundamentally flawed project.

The eurozone’s political elite were no less alarmed. To conservative opinion in Germany, it was a disappointing victory for the forces of moral degeneracy in the ongoing struggle between Teutonic prudence and Latin profligacy. “A race is taking place in Europe between those backing austerity and reform policies on one side and populists on the other”, as one leading German business paper put it.

But exactly what kind of crisis are the financial markets afraid of? And is the conservative vision of the dilemma it presents to the European electorate accurate?

The answer to the first question is not as simple as it might seem. Bare economic statistics hardly suggest the eurozone is a basket case. Unlike the US and the UK, the region runs an external surplus – it exports more to the rest of the world than it imports from it. On the fiscal front, while the US is battling to reduce its deficit from 8.7 per cent of gross domestic product (GDP) and the UK is only a little better off, the gap between eurozone public revenues and spending is much more manageable at a mere 3.3 per cent. And when it comes to debt, there is simply no comparison. Most developed economies can only dream of the eurozone’s 76 per cent ratio of public debt to GDP.

The problem is that this aggregate picture is only half the story: it conceals vast discrepancies between the eurozone’s constituent states. In the honeymoon years following the euro’s introduction, southern Europe gorged on cheap credit while Germany underwent painful reforms. The result was a chronic divergence of competitiveness that was accommodated before 2008 by the accumulation of debt both within and between eurozone countries. So although the region as a whole remained financially quite well balanced, some of its members – notably on the southern periphery – ended up as big net debtors, while others – most notably Germany – became huge net creditors.

As is the way with debt, this all seemed sustainable, until suddenly it didn’t. Starting in May 2010, private lenders repented of their folly and fled the financing of overindebted governments at home and abroad. First Greece, then Ireland and then Portugal were forced to turn to the International Monetary Fund and the European Commission to meet their funding needs. And when, in the middle of last year, the private capital markets began to lose faith in the euro itself, the European Central Bank was forced to announce that it stood ready to bail out any member state to a potentially unlimited degree.

The legacy of financial obligations heaped up in the good times is a problem not just for the cohesion of the eurozone but of its individual member states as well. Italy is the prime example.

There is much to envy about Italy’s economy. Its external and fiscal accounts show only modest deficits. Indeed, if interest payments are factored out, the Italian government runs a surplus – a distant prospect for the Anglo-Saxon economies. But Italy nevertheless has a problem in the scale of the financial obligations that have been contracted over time between constituent parts of its society. Its government sector is dizzyingly indebted – to the tune of 120 per cent of GDP. Its household sector, meanwhile, is a huge net creditor, with a net worth of more than four times this amount – a significant part of which is held in the form of its own government’s bonds.

These debts make Italy’s situation, and the eurozone’s, fragile – not so much for economic but for political reasons. In both cases, there is more than enough wealth to pay the debts that have been run up. The contentious question is whose share of that wealth is going to be commandeered to do so. So the markets are quite right to be spooked by an Italian election in which parties pledged to abandon Mario Monti’s carefully crafted austerity plans won an absolute majority of the popular vote. They recognise that what is at issue in Italy, and in the eurozone as a whole, is not whether there are the means to bake a cake as large as was promised – the aggregate numbers for the region as a whole indicate that European cake-baking is in relatively rude health – but who gets to eat how much of it. And they scent that Italians who voted for Beppe Grillo and Silvio Berlusconi are not content with the current answer.

Conservative opinion insists that the only credible way out of Europe’s debt crisis is for governments to drive through structural reforms to increase productivity and so generate more to go round in the future. Those who suggests otherwise are, as another German newspaper put it this past week, “radical forces and populists, with irresponsible promises and no regard for consequences”.

The truth is the opposite. Structural reform and higher growth would be welcome. Yet Italy’s dilemma, like the eurozone’s, is not over productivity so much as the distribution of wealth. The question is not how the eurozone can generate enough wealth to pay its debts: taken as a whole, it already does. It is who should pay and how much.

Last month’s Italian election showed that the electorate does not think Monti’s orthodox answer to that question is fair. Politicians who come up with workable alternatives should not be reviled as irresponsible populists with no regard for consequences. They should be hailed as the only hope there is. As Keynes wrote in 1923, “The absolutists of contract . . . are the real parents of revolution.”